Economic Muscle with a Dash of Uncertainty

On February 19 and February 20, the S&P 500 Index eclipsed its prior all-time high set in late January, according to data provided by the St. Louis Federal Reserve.

What helped lift the index to a new high?

1. The economy has been expanding, which supports corporate profits.
2. Corporate profit growth is strong as Q4 S&P 500 profits are on track to rise an impressive 17%, per LSEG, as of Feb. 28—with all but 4% of S&P 500 firms having reported in Q4.
3. While discussions of rate cuts this year have waned, Fed Chief Jerome Powell has avoided mentioning any possibility of additional rate increases, despite stubbornly high inflation.

Despite the upbeat mood, uncertainty crept into trading late in the month, and part of the problem has been the persistent threat of tariffs.

The new year is young, and the threat of tariffs isn’t new. But investors seemed to be taking them in stride. Observe the consecutive new highs for the S&P 500 during the third week of February.

In essence, investors don’t (or didn’t) appear to believe the president will follow through on his threat to levy tariffs. Instead, they view it as a strategy to gain concessions.

In other words, investors have adopted a glass-half-full attitude.

But as February ended, the ‘will he or won’t he’ significantly raise tariffs shifted to ‘he might.’ The president said on his social media platform that tariffs on Mexico and Canada will be enacted this week. However, it is not clear whether this is merely a threat to extract additional concessions.

First, let’s discuss the potential economic impact of tariffs and why it is creating economic uncertainty among investors and some volatility.

Investors and financial markets view trade barriers as an impediment to economic growth.

1. Tariffs may boost inflation, at least over the shorter term.
2. Tariffs may slow economic growth as trading partners retaliate and erect walls to U.S. exports.
3. While higher barriers to U.S. markets might benefit some domestic industries, overall, however, tariffs lead to increased economic uncertainty (Figure 1), which can undermine business confidence and business spending.

Despite the worrisome rise, the index isn’t designed to foreshadow a recession, but it illustrates that economic anxieties are injecting a degree of uncertainty into the economic narrative.

Additionally, measures of consumer confidence, including a closely followed gauge from the Conference Board, fell in February amid heightened economic uncertainty and worries about inflation.

That said, let’s be careful not to overthink soft measures of economic data like consumer confidence surveys.

While some economic reports hint at a slowdown, it is too soon to declare that last year’s robust pace of economic growth has been replaced by an economic soft patch. Why? One month is simply a data point, it’s not a trend.

Perhaps weak consumer spending early in the year was weather-related. Besides, it’s not unusual for the data to vary from month to month.

Investor’s corner

Investors bracing for tariffs and the possibility of softer growth have shifted into more defensive sectors (Wall Street Journal). Note that the Dow Jones Industrial Average, which has lagged during the bull market, is off to a respectable start this year, while riskier high-flying sectors, such as technology, are struggling (the Nasdaq).

We are mindful that market volatility may lead to uncertainty, but we encourage a long-term perspective that avoids decisions based on recent market action.

Be leery about trying to time the market. Market timers occasionally get lucky, but consistently timing peaks and valleys is nearly impossible.

Your financial plan enables you to make more thoughtful investing decisions, removing the emotional component that may cloud decision-making when stocks are surging or volatility sets surfaces.

Earnings Impress

On January 13^th, the Wall Street Journal published an article entitled “Investors Hope Earnings Season Can Revive Faltering Stock Rally—With the Fed unlikely to cut interest rates as quickly as hoped, corporate earnings growth becomes even more critical.”

It’s not unusual to see a financial website write a story expressing concerns about the upcoming earnings season—in this case, Q4 2024.

As the season unfolds, we typically see firms top conservative profit estimates, and Q4 was no exception, per LSEG. As the new year began, LSEG expected S&P 500 companies to report a 9.6% rise in profits compared to one year ago (estimate published by LSEG as of January 1).

With 85% of companies having reported Q4 results, LSEG’s survey pegs Q4 profit growth at 15.7%, the best showing in three years. That’s well ahead of the early forecast.

In part, strength in profits among some of the large tech firms is helping drive earnings growth. In part, the economy is expanding, and the public is spending money, which also supports corporate profits.

Stronger profits contributed to rising stocks during the current earnings season, and the S&P 500 Index achieved record closes last Tuesday and Wednesday, according to MarketWatch. These records occurred before a selloff at the end of the week.

Other factors also influence the direction of equities, such as interest rates and the economic outlook. Furthermore, developments related to tariffs may affect the economic outlook. Anxieties about tariffs have been an on-again, off-again headwind over the last month.

While the movement in stocks doesn’t have an immediate one-to-one correlation to corporate earnings, over a longer period, earnings have a significant impact on stocks.

Explaining Away a Hot Inflation Report

The Consumer Prices Index, as reported by the U.S. Bureau of Labor Statistics (BLS), rose 0.5% in January; the annual rate is up 3.0% versus 2.9% in December.

The closely followed core CPI, which excludes food and energy, rose 0.4% (0.446%, nearly rounded to 0.5%), the biggest increase since April 2023. On an annual basis, the core rate rose to 3.3% in January vs 3.2% in December. It has been stuck between 3.2% and 3.3% for eight months.

On the surface, it was a discouraging report, but if we look deeper, we find some unique factors that contributed to the hotter-than-expected numbers.

To begin with, companies focus on price hikes near the beginning of the year—let’s call it the calendar effect. We observed it last year, and it was evident in 2023 as well. We also noticed it during the low inflation years of the 2010s, as we’ll demonstrate below.

With that in mind, let’s examine the data by sorting through what the U.S. BLS and economists refer to as seasonally adjusted (SA) and nonseasonally adjusted (NSA) data.

Almost all reports, including the CPI, are published on a seasonally adjusted basis. Why? Factors such as the change in seasons, production cycles, model transitions, and holidays can lead to seasonal price variations. According to the U.S. BLS, seasonal adjustments eliminate the effects of recurring seasonal influences from many economic series, including inflation, allowing analysts to identify new trends more accurately.

Let’s review the data from 2010 to 2019 and 2023 to 2024 (three years of the pandemic and supply chain distortions are excluded). While the latter includes only two periods of data, elevated inflation is a new phenomenon in the modern era. It’s all we have to work with.

NSA price increases in Q1 are about double Q2 price hikes for both the 2010 to 2019 and 2023 to 2024 data sets. But inflation is much higher today than it was during 2010. So, early-year price hikes are larger today.

For 2023 to 2024, we observe both a significant increase early in the year in the NSA data as well a large increase in the SA data.

If the pattern persists, expect February and March to register uncomfortably large increases followed by a moderation in price hikes in the spring and summer. Of course, significant increases in tariffs or other economic factors could alter the pattern. While investors are currently looking beyond what appear to be seasonal influences on the CPI, persistently high inflation could postpone or hinder further rate cuts unless an unexpected economic slowdown occurs.